Can one judge put an end to the three-decade old SEC practice of allowing the accused to settle charges without admitting or denying guilt? Probably not. But after two years of warm-up matches, U.S. Judge Jed Rakoff seems determined to go to the mat to settle that question this month. If he succeeds, things will change for the worse for the SEC and for companies that end up in the clutches of its enforcement division.

Judge Rakoff's most recent assault on the SEC's standard settlement practices came in response to the SEC's proposed agreement with Citigroup that was announced last month, but he has been making things increasingly uncomfortable for the SEC for over two years now. In September 2009 Judge Rakoff railed against the SEC's methods after he was asked to approve the SEC's settlement of a lawsuit against Bank of America in which the SEC alleged that BofA “materially lied to its shareholders” in a proxy statement. In the BofA case, Judge Rakoff expressed his distaste for standard language in the SEC's settlement agreements stating that the defendant “does not admit nor deny” the SEC's allegations. He also took issue with the fact that the SEC failed to allege any specific facts against BofA. He went on to label the proposed settlement “a contrivance designed to provide the SEC with the facade of enforcement … [where] the SEC gets to claim that it is exposing wrongdoing on the part of Bank of America in a high-profile merger; the 'bank's management gets to claim that they have been coerced into an onerous settlement by overzealous regulators. And all this is done at the expense, not only of the shareholders, but also of the truth.” Rakoff ultimately approved a revised consent order in the BofA settlement that provided more facts, but called it “half-baked justice at best.”

The SEC avoided any further collisions with Judge Rakoff until last March, when he again admonished the agency for its settlement terms with Vitesse Corp. Taking aim again at the “without admitting or denying” language, Judge Rakoff argued that while such a policy might be defensible if only private parties were involved, it wasn't right for an agency of the United States. “Although we claim that these defendants have done terrible things, they refuse to admit it,” he wrote. “And we do not propose to prove it, but will simply resort to gagging their right to deny it.”

In the Vitesse case, however, Judge Rakoff again held his nose and approved the settlement, rationalizing that the individual defendants had at least admitted their guilt in parallel criminal proceedings, and that the company had “effectively admitted the allegations of the complaint” through its payment of a total of over $5 million between the SEC case and a private class action. He added this time, however, that he was “reserving for the future, substantial questions of whether the Court can approve other settlements that involve the practice of ‘‘neither admitting nor denying.''

Although Judge Rakoff raises many legitimate points about the drawbacks of the current SEC settlement process, the alternative of requiring an admission of wrongdoing carries a lot of baggage of its own. In short, the imperfect process now in place still seems to be the best alternative.

Last month the SEC Enforcement Division's Structured and New Products Unit announced that it had filed a settled enforcement action against Citigroup Global Markets, and trumpeted the settlement as its third-largest “financial crisis enforcement action” ever. Specifically, the SEC alleged that Citigroup structured and marketed a $1 billion collateralized debt obligation (CDO), exercised significant influence over the selection of $500 million of the assets included in the CDO portfolio, and then “took a proprietary short position against those mortgage-related assets from which it would profit if the assets declined in value. Citigroup did not disclose to investors its role in the asset selection process or that it took a short position against the assets it helped select.”

Citigroup agreed to settle the SEC's charges by paying a total of $285 million—$160 million in disgorgement, $30 million in prejudgment interest, and a $95 million penalty—and the SEC filed the settled lawsuit with the Southern District of New York so that it could be assigned to a judge for approval in a “fairness hearing.” Unfortunately for the SEC, the case was assigned to Judge Rakoff, who immediately served notice that he would use the Citigroup case to place the “substantial questions” he had previously raised about the SEC's settlement policy under a microscope.

In an order issued Oct. 27, 2011, Judge Rakoff stated he would hold a hearing to determine if the Citigroup settlement met the legal standard of being “fair, reasonable, adequate, and in the public interest.” To assist in his determination, Judge Rakoff ordered both parties to come to the hearing prepared to answer several questions, including:

•Why should the Court impose a judgment in a case in which the SEC alleges a serious securities fraud but the defendant neither admits nor denies wrongdoing?

•Given the SEC's statutory mandate to ensure transparency in the financial marketplace, is there an overriding public interest in determining whether the SEC's charges are true? Is the interest even stronger when there is no parallel criminal case?

•The proposed judgment imposes injunctive relief against future violations. What does the SEC do to maintain compliance? How many contempt proceedings against large financial entities has the SEC brought in the past decade as a result of violations of prior consent judgments?

•Why is the penalty in this case to be paid in large part by Citigroup and its shareholders rather than by the “culpable individual offenders acting for the corporation?” If the SEC was for the most part unable to identify such alleged offenders, why was this?

•How can a securities fraud of this nature and magnitude be the result simply of negligence?

The SEC issued a statement that it was “looking forward” to responding to the questions raised by the court, but answering those questions is probably the last thing the SEC wants to do. Judge Rakoff's questions go straight to the heart of a settlement process that exists because it works for both the SEC and defendants—not because it is necessarily the best process to produce justice, transparency, accountability, or even the “fairness” required for court approval. As noted by Judge Rakoff in the BofA matter, the current “neither admit nor deny” settlement process works for the parties to an SEC lawsuit because it allows the SEC to claim a victory without having to prove its case, and allows the defendant to put the matter behind it without actually admitting any wrongdoing.

What would be the impact if Judge Rakoff was able to lead a judicial movement to reject the SEC's “neither admit nor deny” settlements?

There would be several significant results:

•Under current law, defendants who have a “full and fair” opportunity to litigate their claims in an SEC action may not later re-litigate the question of whether they violated the securities laws. If future SEC settlements required an admission of liability, this would open defendants up to liability in private civil lawsuits. Companies would therefore have little reason to settle and the SEC would be forced to litigate many more cases.

•The SEC is already in a serious budget squeeze and doesn't have the resources to litigate significantly more cases to a verdict. As such, it would likely be forced to bring fewer cases.

•Individual defendants would have an additional disincentive to settle because an admission of liability could preclude them from subsequently serving as an officer or director of another company.

•As noted in an article by Maurice Pesso following the Vitesse case, an increase in the number of defendants choosing to litigate until a final judgment would dramatically increase the amount of defense fees incurred by defendants and covered under D&O policies. On the other hand, if a defendant takes his securities fraud case to a jury and loses, the D&O insurer may be able to then completely deny coverage for the defendant, and even seek reimbursement from the defendant of all defense costs that it has previously advanced.

•The SEC might start bringing many more of its enforcement actions as administrative proceedings, which are not subject to approval by federal judges like Judge Rakoff. Rather, APs are adjudicated by administrative law judges who are employed by and typically friendly to the SEC.

At the Nov. 9 hearing before Judge Rakoff to address these questions, an SEC lawyer took issue with the court's assertion that, due to the “neither admit nor deny” language, the public could not be sure that Citigroup actually did anything wrong. The SEC stated that given the allegations in the complaint and the hefty fine, the public would not be left wondering. Unpersuaded, Judge Rakoff tested this statement by asking Citigroup's attorney, Brad Karp, if the bank would admit guilt. “We do not admit the allegations,” Karp said as the courtroom filled with laughter, “but if it's any consolation, we don't deny them.” Judge Rakoff said he would issue a written opinion with his ruling on the settlement.

Although Judge Rakoff raises many legitimate points about the drawbacks of the current SEC settlement process, the alternative of requiring an admission of wrongdoing carries a lot of baggage of its own. In short, the imperfect process now in place still seems to be the best alternative.